Retail Carnage (Part 1) – Perception vs Reality

As a value investor, it should not be surprising that I have been spending a lot of time on the retail and restaurant sector over the last year or so. The space has been pummeled by Wall Street in recent quarters, as the thesis gains steam that we have essentially reached “game over” for traditional businesses. We will buy all of our stuff from Amazon (AMZN) because it is the only rational choice when we are offered a vast selection, great prices, and fast delivery. The same goes for our dining habits; why not have our groceries and meals delivered too? That way we can binge on our favorite Netflix (NFLX) shows without ever being bothered to leave the house to run errands.

I am not going to tell you that these trends are not real. Heck, I am an Amazon Prime member who subscribes to Netflix. The only time I visit an actual pet store is when Amazon is temporarily sold out of the pet food I need. I get it.

I guess my background as a fundamental evaluator of stock prices, though, tells me that the simple “macro” call (which is to avoid investing in any business that is being “Amazoned”) is not automatically the right one. I have always followed the premise that stock prices are a function of the underlying cash flow of the business. As a result, as long as a public company is producing free cash flow, it has value. Accordingly, if the financial markets are mispricing the intrinsic value of that cash flow, there is an opportunity for investment gains. Just because the internet has changed the landscape in many sectors of the economy, it does not follow that the link between cash flow, company values, and investment returns has somehow been rendered obsolete.

But if you have been watching the stock action in these industries you can not help but realize that Wall Street is not really valuing these stocks on cash flows right now. Good luck trying to justify Amazon’s stock price with numbers. Instead, investors simply conclude (correctly, if you ask me) that they are going to take market share in any number of sectors and the end result will almost surely be a higher stock price years down the road. It is more of an “over/under” bet (the line being their existing business today) than it is a prediction about exact profit levels.

And the flip side is also true. Bricks and mortar retailers are being valued at some pretty insane levels in many cases, especially if you happen to have stores in malls. But you can justify that if you ignore the actual numbers and simply make a more general prediction that 5 or 10 years from now there will be no reason to visit a mall or open air shopping center.

For a while now I have been trying to pick and choose attractive investments in these sectors where the sentiment does not line up with the actual financial results of the businesses. It has been a frustrating endeavor with very mixed results. It has become clear to me than in many cases the stock prices are simply not going to line up with the underlying profits or asset values, unless the company takes a proactive role in narrowing the gap (e.g. through a sale or some sort of transaction that “proves” the values). As the market continues to underprice retail-related assets, I think we will see more and more companies take a proactive role, though movements on this front have been muted so far.

But until that happens, I have concluded that the better way to proceed is perhaps to focus on the companies that not only are generating profits over and above what their stock prices would indicate is possible or likely, but moreso on those that are paying a substantial percentage of those profits out in dividends. After all, if Wall Street does not believe the cash flow is sustainable, market participants may never price a public share at a fair price. However, if your investment thesis is that the profits will be there, and they are paid out to you on a quarterly basis, then the stock price itself becomes less important. Put another way, you do not necessarily needs others to agree with your investment thesis for it to be profitable. The commonly referenced Keynes quote applies here: “the market can remain irrational for longer than you can remain solvent.”

Let me give you two examples that show what I mean. Let’s venture into the lion’s den and look at two department stores; Dillards (DDS) and Kohl’s (KSS). I happen to think both are severely mispriced, but the financial community has concluded that these entities will not survive long-term as profit-producing businesses. Let me quickly throw out some bullet points for each to argue that while they might not be well-positioned competitively, their stocks are mispriced.

At $36 and change, Kohl’s shares trades at a market value of $6.3 billion (net of debt the enterprise value is a little less than $8.5 billion). Over the last five years the company has produced cumulative free cash flow of more than $5.2 billion. I estimate free cash flow in 2017 of roughly $1 billion.

Quite frankly, at 6x free cash flow, the equity at current prices is being priced as if the company’s profits are on a perpetual path of double-digit annual declines. And yet if we look at KSS’s revenue pattern over the last five years, it does not appear to be so bleak. In 2012 revenue was $19.28 billion. Estimates for this year are $18.49 billion. That is a 4% drop over a 5-year period. Hardly catastrophic. But I know… it’s a department store, how on earth could anyone invest in a department store in 2017? Well, because they are earning $1 billion a year and trade at 6 times that figure.

What is even more interesting is that there is a margin of safety even if revenue starts to decline at 5% a year instead of the recent path of 1% per year. You see, Kohl’s owns more than half their stores outright. For more than 1/3 of their store base they also own the land underneath the building. On their balance sheet, the gross book value of the owned land and buildings stands at more than $9.1 billion (less than the current enterprise value). And real estate prices go up over time, so there is a good chance that the $9.1 billion figure is understated relative to current market value.

Next, let’s talk about Dillard’s. DDS is another department store chain but it is seen as being in even worse shape because they operate mostly as anchor boxes in enclosed malls. At $48 per share DDS carries a $1.5 billion market value ($2.0 billion enterprise value including net debt). Last year free cash flow was more than $400 million. This year I project $300 million. So again we have a company that trades at an insanely low multiple of annual free cash flow. It is even cheaper than Kohl’s, with the cumulative free cash flow of the last five years totaling more than $1.9 billion.

And again you would think the business was in free fall based on the price of the stock. But when you look closer you will see that five years ago annual revenue was $6.6 billion and this year it is on track to be $6.1 billion, so it will take a long time for DDS’s business to go away.

Dillards also owns a ton of its stores, even more than Kohl’s. Of the company’s 49.2 million square feet of selling space, they own 44.1 million. The gross book value of the land and buildings at the end of last year was just under $3.2 billion (vs a $2 billion enterprise value). And again, that number is probably too low. In fact, at current prices DDS stock trades at roughly $45 per share foot of owned real estate. To give you an idea of how low that is, Sears recently spun out more than 250 of its stores into a publicly traded company that the market is valuing at $75 per square foot. Obviously Dillards and Sears store space is similar given that they are both anchors in enclosed malls.

So what is an investor to do? Most right now are simply taking the position that stocks like Kohls and Dillards are “uninvestable” because surely department stores are going to vanish. And yet they keep producing hundreds of millions of dollars of free cash flow every year. Clearly that profit stream has value.

A year ago I would have said I preferred Dillards over Kohl’s because it appeared to be even more undervalued. But the market does not seem to care about actual values, and there is no indication that these companies will take steps to demonstrate their intrinsic value by going private or selling stakes in their owned real estate, or whatever other options there might be.

If you asked me the same question today I would choose Kohl’s because they pay a big dividend and that might be the only sure way of earning a return on my capital given the current sentiment in the market. In fact, KSS just raised their annual dividend by 10% to $2.20 per share. I am sure that many people saw that headline and thought it was crazy. How can Kohl’s raise their dividend? Aren’t they dead in the water? Others who simply see the dividend yield of 6% on their computer screens probably come to the conclusion that the payout ratio is unsustainable. After all, since when do retailers pay out a 6% dividend? In the past 3% was a high yield for a retailer and reserved only for bellwethers like Wal-Mart.

So why am I confident that Kohl’s can pay the 6% dividend? Because last year they paid out $358 million in dividends but earned free cash flow of $1.38 billion. They only paid out 26% of their earnings in dividends! In fact, they actually repurchased more stock ($557 million) than they paid out to shareholders. Needless to say, the dividend is safe. In fact, they will probably increase again next year. All of this is true because the stock price and the underlying cash flows of the business are out of whack.

The issue for Dillards investors is that they are choosing to buy back stock and not pay out a large dividend (they do have one, but it is a measly 0.5% annually). While buying back undervalued stock is accretive to investors, it will be tough for those investors to be happy if the stock price is perennially mispriced and the company does not take action to fix the problem. Absent a deal to take the company private or monetize their real estate, it is not clear how the stock price will ever be at a more rational level.

So I think dividends need to be placed higher on the importance scale within the retail sector than they ever have before. They allow investors to lock in some of their expected capital return without worrying about what the stock market claims their shares are worth. As they say, “money talks.”

Stay tuned next week for Part 2 of my Retail Carnage post. For that I will be focusing on the public real estate investment trusts that serve as the landlords for retailers, as they are also stuck in the market’s current disgust of anything related to bricks and mortar retail.

Full Disclosure: Long shares of Amazon and Kohl’s at the time of writing, but positions may change at any time

8 thoughts on “Retail Carnage (Part 1) – Perception vs Reality”

“Thesis : retailer with a margin of safety due to real estate assets” reminds me of Sears. As anchor stores, their real estate might not be worth once they close and depart. A more granular analysis could confirm the thesis or not. But the most important thing is that management needs to take the right action to deal with unavoidable decline. Kohl 5y CDS is at 2.4% Given that most maturities are after 2022. You leverage that 3 times and it looks better than the dividend and less volatile except if you expect a short term catalyst for the stock.

– It would be interesting to see the real “net debt” if the retailer lease obligations were all capitalized.
– Much of Dillard’s RE is 2 story buildings….the 2nd story is of very little value.
– I unfortunately waded into the B mall space, it’s tough. Those anchor boxes are very expensive to repurpose and demise, rents typically don’t afford much of a return on that cost. I will actually hazard a guess that much of the lower tier malls are worth less than zero as the cost to repurpose them is much too high relative to rent levels in these markets.
– All that said, the death of retail theme these last 2 months is way overblown.

I think the difference this time is that the pace of the deceleration is getting worse, not to mention how late in the recovery cycle we are (unemployment 4.3%, wages barely growing). I also don’t know who is the buyer of these doors- it’s certainly not likely another department store. Go-cart tracks seem a lot less profitable, but I’d have to look at the numbers. Certainly some valid points on FCF vs div/buyback, but if fixed costs aren’t coming down as quickly as revenue is, that FCF shrinks quickly.

Looking at revenue decline instead of Net Income decline makes no sense because margins are contracting massively. DDS earnings went from $328M in FY2015 to $173M in FY 17 – that is a -27% decline. You do that over the next 7 years and you are essentially toast – 100%, but working capital and capex intensity increases as companies struggle and become more desperate to survive. Then you take the land and sell it and you got to pay employees, A/R, fees etc. so it doent accrue all to the equity holders.

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